Investment Management Alert

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1 November 2010 Authors: George P. Attisano Clair E. Pagnano Joanne A. Skerrett K&L Gates includes lawyers practicing out of 36 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit President s Working Group Details Further Reform Options for Money Market Funds On October 21, 2010, the President s Working Group on Financial Markets released a report detailing a number of potential options to address systemic risks that it believes are presented by money market funds ( money funds ) and to reduce what it views as these funds susceptibility to runs. The report (entitled Money Market Fund Reform Options ) (the Report ) discusses several proposed reforms that it suggests should be reviewed by the Financial Stability Oversight Council ( FSOC ), which was established under the Dodd-Frank Act. The Report was prepared in response to a proposal by the Treasury Department in its white paper on financial reform in June 2009 and is over a year late. The Report makes no recommendations and expresses no preferences regarding these policy options and in fact strives to present the arguments for and against each option. The potential reform options discussed in the Report include: Adoption of floating net asset values ( NAVs ); Mandatory in-kind redemptions; A private emergency liquidity facility; Money fund insurance; A two-tier system of stable NAV and floating NAV money funds; Making stable NAV money funds available only to retail investors; Regulation of stable NAV money funds as special purpose banks; and Enhanced constraints on unregulated money funds. Certain options could be implemented by Securities and Exchange Commission ( SEC ) rulemaking alone, while others would require new legislation, government agency coordination, and the creation of private entities. The Report makes no definitive findings or must do regulatory change recommendations, but rather pushes this subject off to the FSOC and/or the SEC. The options as proposed by the Report are discussed in more detail below. It is unclear whether the Report s discussion of these options will have any material impact on SEC rulemaking or on possible future legislative or other action. Floating NAVs Among the most controversial policy options that have been discussed since the fall of 2008 is requiring money funds to have a floating NAV, which would fundamentally change the nature of money funds and the money fund industry. According to the Report, while a stable NAV is a key selling point for money funds, it also increases the risk of a run on such a fund during times of financial crisis because investors will rush to redeem their shares at $1.00 if they think that the fund is at risk of breaking the buck.

2 In using a floating NAV, rather than valuing portfolio assets at amortized cost, money funds, like other mutual funds, would value their assets using market quotations and would not be able to round their NAVs to $1.00. The Report discusses several advantages of a floating NAV, including: A floating NAV would reduce investor incentives to redeem shares from distressed funds and increase investors tolerance for NAV fluctuations. Since money fund shares are redeemed at NAVs set after redemption orders are received, a floating NAV fund s losses would be borne on a pro rata basis by all shareholders, whether they redeem or not, thereby eliminating or reducing arbitrage opportunities and some of the incentives to redeem when a money fund has experienced a loss. The Report also points out possible disadvantages: A floating NAV could reduce money funds appeal to investors, which could lead to fewer assets invested in money funds and thus less capacity to provide short-term credit. The Report observes that institutional investors could shift assets to offshore, less regulated or unregulated money fund substitutes. A floating NAV might not prevent runs but rather could result in increased investor redemptions, if investors respond negatively when money fund NAVs fluctuate more frequently. Risk management might deteriorate without the discipline required to maintain a $1.00 share price. With a floating NAV, funds would not have as clear a tipping point, so fund advisers might face reduced incentives for prudent risk management. The transition from a stable NAV to a floating NAV industry may be systemically risky and could cause preemptive redemptions. Private emergency liquidity facility The Report notes that policymakers have long recognized the utility of liquidity backstops for institutions, such as banks, that engage in maturity transformation (i.e., borrowing shorter term then lending or investing in order to capture the difference between shorter and longer term rates). An adequately capitalized and financed private facility could provide liquidity to funds that most need it at times of market stress. Depending on its structure, such a private facility might have access to broader liquidity backstops. The Report describes a number of benefits that could be provided by establishing a private emergency liquidity facility: Along with new liquidity requirements in the revisions adopted earlier this year to Rule 2a-7 under the Investment Company Act of 1940, as amended (the 1940 Act ), a private facility could bolster money funds ability to withstand redemptions without selling assets into potentially illiquid markets during a crisis. There would be efficiency gains from risk pooling by providing liquidity to the money funds that need it. A private liquidity facility might provide funds with flexibility in managing liquidity risks if, for example, regulators allowed money funds some relief in liquidity requirements in return for the funds purchase of greater access to the liquidity facility s capacity. A private liquidity facility could internalize the cost of liquidity protection for the money fund industry and provide appropriate incentives for investors. Such a facility, if well designed, would not help funds that take on excessive capital risks or face runs because of isolated credit losses. The Report also notes that there could be a number of challenges in establishing a private liquidity facility: If participation was not mandatory, nonparticipants would free-ride on the industrywide benefits of the facility, and if participation was mandatory, regulatory oversight of the facility would be necessary. November

3 The facility could have inadequate capacity to handle moments of crisis, and its effectiveness during a crisis could be impeded by conflicts between the interests of participating money funds and the facility s shareholders, who might want to limit or restrict liquidity provision. The facility could create moral hazard by diminishing the incentives for money fund managers to maintain liquidity in the funds portfolios. A liquidity facility would do little or nothing to help a fund that had already experienced a capital loss. Mandatory redemptions in kind The Report notes that requiring money funds to satisfy large redemption requests in kind could force redeeming shareholders to bear their own liquidity costs, thus reducing their incentive to redeem and minimizing the transaction costs and reduced liquidity that would be imposed on other shareholders. Redemptions in kind present a number of challenges, however, including: Redeeming shareholders with immediate liquidity needs would have to sell those assets, with consequences for short-term credit markets similar to those that would result if the fund itself had sold the securities. Since the transfer of money fund portfolio holdings may be restricted, delivery of an exact pro rata portion of each portfolio holding to redeeming shareholders may be impracticable, introducing allocation issues into the redemption process. Money fund insurance Noting that the Treasury s Temporary Guarantee Program helped to slow the run on money funds in 2008, the Report discusses a permanent government insurance program for money fund shareholders. The Report contrasts the effects of private liquidity facilities and insurance, noting that unlike a liquidity facility, insurance would substantially reduce or eliminate any losses borne by the fund s shareholders and decrease their incentive to redeem fund shares and thereby set off a run. The insurance option presents a number of practical and policy considerations, including: historical difficulties in fairly pricing and successfully guaranteeing rare but high-cost financial events; the need for new government oversight of money funds similar to that provided to insured banks, and a mechanism for setting appropriate risk-based premiums; the regulatory and economic implications of such government responsibilities; the shifting of incentives for prudent money fund risk management to insurers away from fund advisers; and appropriate limits on insurance coverage in order to avoid giving money funds an advantage over banks and to preserve incentives for large investors to monitor money fund risk management practices. A two-tier system with enhanced protections for stable NAV money funds The Report also discusses a two-tier system that would allow investors (based on their risk tolerance) to choose between two types of money funds, both regulated under Rule 2a-7, stable NAV funds and floating NAV funds. Stable NAV money funds would continue to maintain stable, rounded NAVs, but would be subject to enhanced protections, which might include tighter regulation and required access to an external liquidity backstop. Floating NAV funds would face restrictions less stringent than those imposed on stable NAV funds, enabling floating NAV funds to bear greater credit and liquidity risks. Floating NAV funds would not be required to obtain access to external sources of liquidity or insurance, and most likely would pay higher yields than their stable NAV counterparts. According to the Report, there are several benefits to such a system: A two-tier system could mitigate the systemic risks that arise from a stable, rounded NAV by requiring stable NAV funds to have additional November

4 protections that directly address their vulnerability to runs. Preserving stable NAV funds would mitigate the risks of a wholesale shift to floating NAV funds. Frequent changes in a floating NAV fund s share price would help align investor perceptions and actual fund risks, and would have reduced incentives to redeem early in a crisis. Investors in floating NAV funds presumably would be less risk-averse and more tolerant of NAV changes than stable NAV fund shareholders. During a crisis, investors could shift assets from riskier floating NAV money funds to stable NAV money funds, which would presumably be safer because of their enhanced protections. The Report notes that a two-tier system would face the same challenges associated with creating a private liquidity facility (outlined above). Two-tier system with stable NAV funds reserved for retail investors The Report discusses as a policy option making both stable NAV and floating NAV funds available to retail investors, while restricting institutional investors to floating NAV funds. Noting that the September 2008 run on money funds was primarily a flight by institutional investors, the Report states that this approach could protect the interests of retail investors by reducing the likelihood that a run beginning in institutional money funds could spread to retail funds. This approach could be accomplished with SEC rulemaking without establishing additional market structures. The Report notes, however, that the SEC could face hurdles in defining the two investor classes. Additional disadvantages of this regime include: Large shifts in assets to money funds substitutes. For instance, if many institutional investors are unwilling to switch to floating NAV funds, a prohibition on sales of stable NAV money funds shares to such investors may have many of the same unintended consequences as a requirement that all money funds adopt floating NAVs. The loss of some of the advantages of allowing institutional investors to choose between stable NAV money funds and floating NAV money funds (discussed above). Regulation of stable NAV money funds as special purpose banks The Report states that similarities between money fund shares and bank deposits, including the risk of runs on both, provide a rationale for regulating stable NAV funds as special purpose banks. Under such a regulatory scheme, money funds could see several benefits: Money funds would have a broad regulatory framework similar to existing regulatory systems that are designed for mitigation of systemic risk. Money funds might benefit from access to government insurance and emergency liquidity facilities at a price similar to that currently paid by depository institutions. The existence of explicit capital buffers, access to a liquidity backstop, and deposit insurance might substantially reduce the uncertainties and systemic risks associated with money fund sponsors current practice of discretionary capital support. The Report states, however, that the capital needed to reorganize money funds as special purpose banks may be a significant hurdle to successful implementation of this option. An additional hurdle would be the substantial increase in explicit government guarantees that would result from the creation of new insured deposits. The potential liability to the government might far exceed any premiums that could be collected for some time. Enhanced constraints on unregulated money fund substitutes The Report notes that new restrictions on registered money funds might reduce the appeal of such funds and lead investors to shift assets to unregulated money funds. Because unregulated funds often seek to maintain a stable NAV and have other features making them vulnerable to runs, the Report states that such funds also are likely to pose systemic November

5 risks. The Report discusses policy reforms to address these risks, such as excluding unregulated stable NAV funds from the registration exemptions in the 1940 Act s private fund provisions; these options likely would require both legislative and regulatory action. The Report also notes that banking and state insurance regulators could consider restrictions to mitigate systemic risk for bank common and collective funds and other stable NAV investment pools that are exempt from 1940 Act registration. * * * According to the Report, the SEC will, in the near future, solicit public comments on the options discussed in the Report. Following a comment period, a series of meetings will be held in Washington, D.C., with various interested persons, experts and regulators. Anchorage Austin Beijing Berlin Boston Charlotte Chicago Dallas Dubai Fort Worth Frankfurt Harrisburg Hong Kong London Los Angeles Miami Moscow Newark New York Orange County Palo Alto Paris Pittsburgh Portland Raleigh Research Triangle Park San Diego San Francisco Seattle Shanghai Singapore Spokane/Coeur d Alene Taipei Tokyo Warsaw Washington, D.C. K&L Gates includes lawyers practicing out of 36 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit K&L Gates comprises multiple affiliated entities: a limited liability partnership with the full name K&L Gates LLP qualified in Delaware and maintaining offices throughout the United States, in Berlin and Frankfurt, Germany, in Beijing (K&L Gates LLP Beijing Representative Office), in Dubai, U.A.E., in Shanghai (K&L Gates LLP Shanghai Representative Office), in Tokyo, and in Singapore; a limited liability partnership (also named K&L Gates LLP) incorporated in England and maintaining offices in London and Paris; a Taiwan general partnership (K&L Gates) maintaining an office in Taipei; a Hong Kong general partnership (K&L Gates, Solicitors) maintaining an office in Hong Kong; a Polish limited partnership (K&L Gates Jamka sp.k.) maintaining an office in Warsaw; and a Delaware limited liability company (K&L Gates Holdings, LLC) maintaining an office in Moscow. K&L Gates maintains appropriate registrations in the jurisdictions in which its offices are located. A list of the partners or members in each entity is available for inspection at any K&L Gates office. This publication is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer K&L Gates LLP. All Rights Reserved. November